One Scenario for the End of Scientology

On a recent trip, I met with a number of ex-Scientologists as well as some familiar faces in our community. One question in my discussions always came up:

What is the endgame for Scientology, where the cult closes its doors for good and becomes a minor footnote in the pages of history?

One of the main goals on this blog, as outlined in the original post back in November, is to try to develop and maintain a full scenario for the collapse of the cult. A full scenario would have several different alternatives along with an assessment of the relative likelihood of each of those alternatives actually coming to pass. This is not that document. Over time, I would hope to be able to assemble from different individual scenarios such as this one, the complete assessment of the likely futures that may befall the church, and a series of guideposts that would help us tell which one of those scenarios is coming true.

This is simply one potential scenario, and it is one that had been on my mind, so I shared it with the people I was speaking with.

I think it safe to say that there are so many things going wrong both inside and outside the cult that it is beyond saving. But I also caution that it will be difficult to predict exactly how and when corporate Scientology is brought low. It is important to understand that it will probably take far longer than most people expect for the end game to play out, even if we are confident that the organization is doomed. Parallels to attempts to predict the end of the Soviet Union are telling; though nobody got the “time, place form and event” (in cult-speak) exactly right, the act of trying to predict the unknowable was in fact useful.

Common Assumptions

No matter which scenario you believe will come to pass, there are several common assumptions that I believe will be common to all scenarios:

The cult will fail utterly at attracting newmembers. The damage to the Scientology brand resulting from press coverage of the cult’s bad behavior is irreparable. The Internet has made too much bad news too easily available to those seeking information about Scientology, and virtually all those who come in contact with the cult will easily discover that information. As a result, the battle will be solely about retention of existing members and the pool of new recruits will be substantially restricted to children or grandchildren of existing members. And, of course, the rich donor pool is aging, increasingly broke, and starting to die off.

Miscavige’s replacement (if and when) will be (at best) no more competent than he is. Because Miscavige has so ruthlessly declared and purged anyone who could possibly pose a threat to usurp his role, there is no bench of internal candidates who could step into his shoes if there were a vacancy at the top, for whatever reason. Companies with outstanding management like General Electric have a deep bench of management talent that is actively and constantly groomed for promotion to greater responsibility. And GE’s Board of Directors ensures that the CEO does not spend his time exterminating potential claimants to the throne, but instead continues to keep high-quality management within the company. Needless to say, the board structure to provide checks and balances on David Miscavige’s power does not exist, as he has purged all of the board members.

“AdminTech” will continue to act as a destructive force on the organization.Even if we posit the unlikely, that competent new management takes over and somehow manages to reverse the trend and attract new members, arbitrary decisions that Hubbard made a half-century ago will sabotage the organization and keep it from succeeding. Among many other seeds of disaster planted by Hubbard are the insane use of statistics, financial metrics that measure the wrong goals and inevitably lead to bad behavior, and so much pressure on the staff that it is impossible to build any long-term viability into the organization.

What the End of the Road Looks like

For Scientology to go bankrupt, three things would need to happen:

Lose money from current operations, so that a realistic assessment of forward prospects concludes that there is little chance that the company would be able to turn around its fortunes and resume profitability.

Have cash reserves depleted so that the cult is no longer able to cover operating losses. The cult could lose money for a long time because it has access to cash, whether that is in the form of profits accumulated in past years (“retained earnings” in accounting parlance) or in access to bank loans, that would enable it to withstand ongoing losses.

Lose the ability to conduct operations due to loss of corporate facilities. In other words, if the cult has no cash and also loses control of its real estate portfolio and has no place to conduct business, then it cannot continue to operate.

If the cult runs out of cash, it could sell real estate to raise cash to continue operations, even if those operations are losing money; that is where paying cash for buildings comes in handy because the lack of debt means they cannot be foreclosed, and credit would be available, even if it is a fraction of the purchase price of the building.And if something happened to seize the cult’s real estate operation while it still had significant cash, they could always replace the real estate fairly quickly by throwing cash around.

So it is important to understand that in this scenario, for the cult to go completely bankrupt, it must lose both the cash reserves and the real estate portfolio. It can survive the loss of only one of these two things.

This scenario, then, deals with the circumstances under which the cult could lose both the cash balance and the real estate portfolio and thus have the doors forcibly shuttered.

A History of Operating Losses

My best current estimate is that Scientology remains profitable. According to my best estimates, I believe the cult pulled in around $180 million in 2013 from all sources (services, IAS, Narconon, etc.), and reaped an operating profit of approximately $30 million, excluding one-time legal settlements or reserves to allow for legal settlements in the future. I believe both revenue and profits are down from prior years. But this is hardly a disaster: many businesses of that size would kill to have profit margins like Scientology.

Despite the seeming health of the organization based on one year’s financial results, all is not well. I believe that revenue has declined steadily in the last five years, and that profits have actually declined by an even greater amount.

If the cult sees the revenue decline accelerate due to defections in the wake of disappointment over GAT 2, a drop in IAS donations, the failure of new real estate scams, the shuttering of Narconon centers due to lawsuits and license revocations, or a host of other looming problems, the cult could swing to operating losses. I believe that once it begins losing money, it will be difficult for the cult to restructure in a way that’s needed to return to profitability.

Fixed Cost Business Models Are Great Until They’re Not

Economically, at this point, Scientology resembles a software company rather than a manufacturing enterprise. Software companies are interesting because virtually all of their expenses are fixed in the short term. There are almost zero raw materials used in each unit of product shipped, especially in the Internet era where software formerly shipped on CDs with paper manuals has now been completely shifted to Internet downloads.

In a fixed cost-only organization, any incremental revenue above your forecast turns into nearly pure profit. Suppose Microsoft budgets to sell $15 billion worth of software in a given quarter and plans to spend $10 billion, leaving $5 billion in pre-tax profits. But business is booming and they sell $16 billion instead. About 90% of the incremental $1 billion in sales will drop directly to the bottom line. A revenue surplus of just 6% bumps profits up by almost 20%, and a revenue surplus of 12% boosts profits by an astronomical 40%. That’s a pretty amazing business model, and it is one that propels Microsoft to being one of the most valuable companies in the world, even though its sales are quite a bit smaller than other extremely valuable companies.

While this fixed cost model is a wonderful thing when sales come in ahead of plan, it is equally painful when things go wrong. Suppose now that Microsoft planned to make $15 billion in sales, spending $10 billion to generate sales. But now suppose that, due to a bad economy, sales come in at only $13 billion, 12% below forecast. There are no variable costs in the manufacture of its products, so the entire $2 billion shortfall in sales will drop through to the bottom line, and profits will be only $3 billion instead of the expected $5 billion. That is a deficit of 40%. If that happened, the stock would be demolished, and we in Global Capitalism HQ would be at the head of the pack of investors brandishing torches and pitchforks, demanding that management institute changes to ensure that that screw-up does not occur again.

Manufacturing companies, where the cost to produce each automobile, iPad or cheap plastic doodad are a substantial portion of sales, can manufacture fewer units if they feel sales slipping, and thus cut manufacturing costs quickly. Profits will still decline if sales slump, but the ability to control spending on raw materials and labor cushions the blow so that profits to not fall as far in difficult times as that of a fixed-cost enterprise like a software company.

Scientology Is a Fixed Cost Business

Scientology works exactly like a software company: costs are fixed in the short and medium term, and there is little opportunity to cut labor costs when business turns bad. Unlike a consulting firm, Scientology has benefited for years from the sleeve labor wages it pays its employees, allowing it great profits when it has been in expansion mode. As a result, the cult has no incentive to manage its labor force efficiently. Furthermore, many of the job positions in existence are decreed by “Scripture” as laid down by Hubbard a half-century ago. So even if they wanted to cut costs by laying off staff to gain efficiency, they are prohibited by “religious” requirements.

It is important to understand that staff costs are not zero, even if individual paychecks are close to it. Sea Org staff need to be fed, need to be housed, and need to be shuttled from their apartment prisons such as the Hacienda Gardens facility in Clearwater where Debbie Cook was imprisoned before she exited the cult. I would estimate that total employee costs for the cult are approximately $6,000 per person per year. If my estimate of 5,000 worldwide staff is correct, then labor costs are actually significant, totalling $30 million per year, or about 15% of what I believe the cult’s current annual revenue is.

That 15% of revenue figure sounds pretty cheap, until you realize that a highly profitable software company like Microsoft or Oracle typically spends about 30% of sales on employee compensation and benefits. In other words, while the low staff salaries are a disgrace and are horribly abusive on an individual basis, in aggregate, they do not confer a dramatic cost advantage to the cult. The cost savings from low individual salaries are offset significantly by dramatically more employees that are necessary to generate a certain amount of revenue. Microsoft, for example, did $77.85 billion in revenue in its June 2013 fiscal year with 99,000 employees, or approximately $786,400 per employee (an extremely high number even for the highly profitable software industry). Oracle, another software titan, did about $310,000 per employee. By comparison, using my numbers, Scientology does a paltry $36,000 per employee, disastrous for any regular business.

Equally importantly, the low labor costs lead management to avoid making many decisions about how to manage costs effectively. There’s an enormous amount of inefficiency baked into Scientology’s management practices, and the longer the cult has been able to get away with insane inefficiencies, the harder it will be to fix them.

… So Further Sales Declines Can Quickly Lead to Recurring Operating Losses

While Scientology is probably profitable and generating cash today, results can quickly move from profits to losses. Let’s suppose that the cult loses 15% of members in 2014 due to disappointment with GAT 2, disconnection, death, and a host of other causes, a modest acceleration of the 5% to 10% decline I think we have seen in the last few years. And, as we would expect, the cult at best does not undertake any significant cost reduction efforts.

In that case, we’d see revenue dropping by 15%, from $180 million to about $150 million. Without aggressive cost reductions, profit would go from $30 million to just above break even, perhaps $5 million. The following year, assuming a return to a modest 5% decline in membership, the cult would go into the red for what I believe would be the first time in many years.

I believe that the downside risk in the next two years is actually greater than a proportional decline in revenue. There are unique pressures building on the cult’s revenue and expense lines including:

Death or defections among the whales. A handful of top donors like Bob Duggan are probably contributing $10 million or more per year, a significant portion of current operating profit. Losing the income stream from of any of these individuals would have a rapid negative effect on profits.

Collapse of Narconon. I believe Narconon contributes less than $10 million of profits. But that empire has come under immense pressure lately in the wake of multiple lawsuits, and suits are being filed at an accelerating rate. I believe that there are multiple insurance fraud investigations under way in the wake of discovery that perhaps 20% of Narconon Georgia’s billings (if I recall correctly; don’t have time to check the numbers) were from fraudulent claims.

Aging of the Freewinds: Some data points including GPS data of the ship’s location suggest that the Freewinds business has basically collapsed. At the same time, the ship is nearly 50 years old, long past the normal lifetime of a commercial vessel. Unexpected repair expenses to hull plating or to engine room equipment are likely to be expensive, driving this minimally profitable operation deeply into the red.

But while the risk of going into the red and staying there for a long time is increasing, the reserves presumably mean that David Miscavige is not at this point particularly concerned about the future viability of the organization.

Losing the Reserves

If the cult starts losing money, reserves can sustain it without requiring significant retreat from its current operating posture. This naturally sparks the question as to how those reserves might be decreased and that cushion eliminated.

How Much Money, Exactly?

I believe that the total cash position of the cult is made up of three different figures:

Sea Org reserves:this figure represents the profit from operations for most of the cult, particularly courses delivered at Flag. I recall an interview with Mat Pesch, a longtime staffer, where he said that the Sea Org reserves were essentially depleted in the early 1990s. Given a reasonable estimate of profitability from delivering services over the last 20 years, I estimate that these reserves are about $400 million.

IAS “war chest:” this amount represents the donations to unrestricted IAS funds over the last 15 to 20 years. Some of these donations were used to build the Superpower building and for some other projects, plus used for legal settlements, I believe that the net balance currently is about $250 million, a bit less than the aggregate donation amount that I estimate at around $400 million.

Deposits: this represents money paid in for services not yet rendered. In cult accounting jargon, these referred to as “advance payments” (AP). I will use the term “deposits” since “AP” has a specific meaning in finance in the rest of the world (“accounts payable”). Recently, when I’ve been interviewing former members for background information, I have asked how much money they have on deposit with the cult. Anecdotally, the average seems to be about $20,000-$25,000, but my sample is not terribly broad, consisting mainly of people who were “in” for decades. I think it reasonable to believe that the average balance from people who put money on deposit and then walked away might be closer to $15,000, but over the last 20 years, I think it reasonable to believe that 40,000 members walked away from money that they should have been repaid rather than risk the wrath of the cult. Total balance here I believe to be approximately $600 million.

When you add that up, the total cash balance in the cult appears to be in the neighborhood of $1.25 billion. I don’t think some estimates that have ranged as high as $5 or $6 billion are credible because I don’t think there are that many members over the last 20-25 years with enough disposable income to support that kind of accumulated profits.

I believe that most of this money is immediately routed offshore into non-interest-bearing bank accounts. Hubbard was fearful that the government would step in and seize cult funds without warning, and Miscavage has certainly continued that sort of paranoia. While the reserves may seem unassailable, beyond the long arm of Uncle Sam, things may not be as safe as they seem.

How Could the Cult Lose That Money?

A $1.25 billion fortune is hard to squander, even if the cult is losing money at an increasing rate. Suppose the cult swings from a $30 million per year profit to an ongoing series of losses a similar amount. Those reserves would allow the cult to sustain operations without making any significant changes for almost 40 years. Clearly, then, the cult is not going to go bankrupt from operating losses alone.

An unanticipated external force would need to come in and reduce those cash balances significantly. Only if the reserves were decimated due to an unforeseen event would ongoing operating losses imperil the cult’s ability to operate. So what could possibly put this enormous cash hoard at risk?

I believe the Garcia lawsuit is the beginning of a wave of lawsuits that could significantly deplete cash reserves as claims are settled. Of the suit is about fraud in fund raising for Super Power, the argument revolves around something that, if allowed to stand as precedent, will be a shining beacon to guide attorneys in similar suits in the future: that the repayment mechanism is unconscionable, because it is inherently rigged against anyone seeking a repayment of funds.

Tony Ortega’s coverage of the Garcia lawsuit has mentioned in several places that the Garcia’s attorney, Ted Babbitt, has also been recruiting other plaintiffs to pursue similar actions against the cult in the future. Interestingly, one of the details that arose in the failed motion on the part of the cult to disqualify attorney Babbitt as counsel was the revelation that he was using a former cult attorney, who worked for the cult many years ago, to help recruit future plaintiffs.

I therefore believe that there is a “cottage industry” waiting in the wings made up of a network of law firms coordinating their efforts who will sue the cult for either fraud in IAS donations or for repayments, once the arbitration scheme is exposed as a sham. As I have said before on Tony’s blog, since Miscavage micro-manages all legal affairs, a wave of individual lawsuits on this front will overwhelm him and leave him unable to function in other capacities. This will likely lead to rapid settlements including punitive damages.

I believe that, if this prediction of an avalanche of individual lawsuits comes to pass, the next step would be a class-action suit for all persons who have monies on deposit with the cult. In many class-action suits, damages are estimated, and by the time attorneys fees are deducted from the settlement, class members see recovery of only a few pennies on the dollar of what they believed their damages to be. That is a function of the difficulty in calculating damages, and of the incentive for companies to settle the damages are difficult to prove. Price-fixing cases, such as charges of fraud and diamond pricing or other similar actions, are examples of this sort.

I have talked to many ex-members, virtually all of whom have walked away from deposits, some in the six figure range, who are not interested in the expense and potential risks involved in suing the cult individually, but every single person I have talked to would happily sign up for a class action suit.

Unlike most class actions, damages incurred by each class member suing Scientology for refund of advance payments are trivial to determine: people have statements showing the amount on deposit, and the church should have tons of relevant records that would easily be discoverable. In other words, it is reasonable to believe that a class-action suit, if successful, would recover 100% of damages, rather than pennies on the dollar. An appropriately aggressive class-action attorney would insist that legal fees be added on top of the damages recovered for class members rather than deducted from them.

If my estimate of the deposit amount is correct, and if you add on legal fees at a typical 30% contingency rate, it is conceivable that a successful class-action lawsuit could deplete the majority of the cult’s reserves. Once those reserves are depleted, then operating losses are increasingly dangerous. But since operations are prescribed by “scripture,” the cult has little flexibility to cut costs.

But Could Plaintiffs Collect?

The corporate restructuring in the early 1980s, as documented by Denise Brennan and others involved, was clearly intended to shield the organization from liability for bad behavior and from asset seizures, using an impenetrably intertwined maze of onshore corporations, offshore shells and mysterious trusts.

Plaintiffs in a suit for refund of deposits would have to convince a judge to pierce all of these corporate structures in order to lay hold of assets to recover something for the victims of this fraud. When that corporate structure was laid down a third of a century ago, it was extremely difficult for courts to order that complex corporate structures be collapsed to get at the money.

The world is very different today as a result of changes to the international financial system made in the wake of September 11 terrorist attacks. The PATRIOT act and extensive behind-the-scenes diplomacy on the part of the US government has dramatically reduced the ability of enterprises to hide money in complex international corporate structures, and has made it much easier for the government to collapse networks of shell corporations and to seize funds held in offshore accounts ostensibly beyond the reach of justice. It is still not easy to do this, but it is far easier than it ever has been.

At the very least, it is reasonable to believe that the government would be able to sequester those funds and prevent them from being imported back into the US for use in daily operations of the cult. In other words, while it could not seize cult funds that remain outside the US, it could seize funds that are repatriated to fund operation. That’s why the move to operating losses is critical: that’s the circumstance in which the cult would be forced to repatriate cash, where it then becomes vulnerable. Losing money erases the benefit of the complex corporate shield.

In other words, it does not matter whether the government is actually able to seize cult funds held overseas. Instead, if the government is merely able to freeze those funds to prevent the cult from being able to make use of them itself, then the cult is essentially denied the money to backstop its operating losses, and the effect on operations is essentially the same as if the reserves were seized for lawsuit settlements: the cult can no longer use them to continue to operate once it starts losing money.

From Ideal Orgs to the Auction Block

In addition to being unable to use the reserves to sustain losses, the cult needs to be denied the use of its facilities. No company selling to the public can exist without bricks and mortar buildings.

In the case of Scientology, since the cult does not finance real estate purchases, instead paying cash for everything, it would seem as if real estate portfolio is a bulwark of strength against the “wog” world wishing it harm. While that is certainly true on the surface, there are several circumstances under which the cult could actually lose control of the real estate portfolio.

Many people wonder whether the Ideal Org strategy is a secret investment vehicle for the cult. As I have said on many occasions, I do not believe this is the case. I believe it is a pure marketing vehicle to attract new members (though one that is doomed to fail) and an opportunity to scam parishioners out of savings by collecting more in donations in the cult actually spends on purchase and renovation of these properties.

Let’s presume that over the next 3 to 5 years, the cult is successfully sued on a broad scale for repayment of deposits and further malfeasance. But it’s further assume that, despite the best efforts of attorneys to unlock the doors to the cash vaults, that the reserves are not available for use of settlements. Attorneys may then move for seizure of the buildings in lieu of offshore cash to satisfy judgments.

If I am correct in believing that the aggregate value of settlements for repayment of outstanding deposits is at least $500 million, I believe that that exceeds the market value of the cult’s real estate portfolio.

The real estate portfolio divides naturally into three categories:

Headquarters facilities, like “Big Blue” in Hollywood, Superpower and Flag in Clearwater, and Int Base in Hemet. While the oldest of these facilities were purchased for nominal sums and are undoubtedly worth far more than the cult paid decades ago, they are not in particularly desirable locations and, more importantly, the custom designs and improvements that the cult has ordered are of little value to future tenant, depressing the market value of these properties significantly. Anyone who purchases the buildings out of an asset sale would have to make significant modifications to make it useful for almost any other purpose. If we estimate that the cult has invested $300 million in new construction at Int Base, it would realize very little of that if it sold that facility.

Local orgs, including both older facilities and Ideal Orgs, are typically located in out-of-the-way areas without much potential for conversion to retail or high-quality office space. The cult does a good job picking older, historic buildings and doing quality renovations, but I do not believe that its strategy will maximize resale value. The odd locations and the extremely specialized renovations (small auditing rooms without windows, large “Chapel” rooms too big for most corporations to use as conference rooms) will depress resale prices. In most cases, as evidenced by resale of facilities that the cult purchased for Ideal Org use and later resold, including Portland and Budapest among many others, it is unlikely that the cult will recapture the initial purchase price of the building, much less the high cost to pay for renovations.

Specialized facilities, including some of the CST sites with the storage vaults, are even more over-improved relative to their locations than the other types of buildings. It is unlikely in the extreme that a buyer would pay a premium relative to surrounding ranch properties for the paved airstrip and the expensive vault buildings at the New Mexico CST facility, to cite just one example.

Some anti-Scientology activists believe that the IRS may take action to revoke the cult’s tax exemption in the near to medium term future. If the IRS does take action, it is entirely possible they may seek to seize the real estate in the event that the cult enters into a significant settlement for violation of the 1993 agreements. One of the key provisions of the 1993 agreement is prompt repayment of deposits and refunds for dissatisfied customers, something that the cult has clearly willfully ignored over the last 20 years.

Of particular interest in considering whether the IRS might begin to reconsider the cult’s tax-exempt status is the idea that the government may be able to prove that the 1993 agreement was entered into fraudulently by the cult. If the government were able to obtain evidence that the cult committed fraud in negotiating that agreement, then it would be able to pursue damages not only for civil enforcement actions over the last few years, but potentially going back much further, and even re-opening the cases that were pending in the late 80s and early 90s, where the amounts being litigated were substantial.

I have said repeatedly that it is unwise to presume that the government can move aggressively against the cult, even if it wants to. The arcane details of the federal budgeting process means that individual portions of the government are restricted in the funding they can bring to bear for enforcement actions against the cult. In other words, IRS enforcement attorneys have a limited budget, even if potential recoveries are substantial. It is possible that the government could decide not to pursue the cult in order to maximize its “bang for the buck” particularly in maximizing deterrent effect by chasing after a large number of smaller scale tax dodgers.

It is thus difficult to assess the probability that the IRS will begin enforcement action. But if it does, it is reasonable to suspect that the IRS may move to seize real estate since it is likely to be easier to grab than cash held offshore. If the IRS were to do so, and if through either litigation or through IRS action, the church is essentially denied use of reserves, then we get to scenario where bankruptcy could happen within a relatively short period of time. Note, however, that this “relatively short period of time” would begin only after the cash reserves are taken out of the equation through several years of litigation, and after the IRS places liens on or seizes facilities. Thus, the clock on that prediction would only start running at least 3-5 years from now, and possibly longer.

Conclusions

Again, I stress that this is not necessarily the scenario for the collapse of the cult. It is merely a possible scenario, one of several. I’ll detail others in future blog posts, until we have a range of possible outcomes.

This scenario is not going to happen overnight. I believe that litigation for repayment of deposits would take a minimum of three years and more likely five years to wind its way through the courts, either to resolution or to a point where we can predict confidently that the cult will lose. The dénouement from there could take another couple of years. It is thus unwise to get one’s hopes up that the cult will collapse soon, even if the best case articulated here comes to pass. I believe it will happen in our lifetimes, but I would advocate against holding out hope that it will be in the next year or two.

This scenario is one in which the cult’s ability to operate is extinguished due to external circumstances that bring about its end. Other scenarios would have the cult somehow able to operate as a shadow of its former self, which leaves the potential for it to continue to do evil in the world, diminished but not extinguished.

Author: John P.

John P. is a Wall Street money manager and IT technologist fascinated by irrationality in all its forms, and Scientology most of all. He's a lifelong Steely Dan fan.
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